Wal-Mart Looks Cheap, But Is It A Buy?

Summary

Investors have been disappointed by guidance for increased investments over the next few years.

I think Wal-Mart is making the right moves, even though they're painful in the short term. With that, I believe the stock is trading below its fair value.

Given that I have a limited analytical edge on mega-caps, I typically look at them more for general context than as specific investment ideas. Every so often, though, you can have an edge simply by being patient and having a longer time horizon than the market. This appears to be the case with Wal-Mart (NYSE:WMT) today - while the market really, really doesn't like the guidance for a 6-12% EPS decline in FY17, I think the competitive position is still strong, and the company has merits as a long-term investment.

There Are Challenges, But Wal-Mart Seems To Be Rising To Them

The overhang on the stock has been the company's guidance for significant investments over the next few years, primarily in wages, but also in e-commerce. The latter raises issue of competition. As a happy Amazon Prime (NASDAQ:AMZN) member who actively avoids most stores not named Costco (NASDAQ:COST), I'm hardly bright-eyed and bushy-tailed about the future of in-store retail. That said, I think there are some businesses that make more sense online than others. Grocery, in particular, is not one of them; what Wal-Mart is doing with pickup seems much more meaningful than grocery delivery in most parts of the country.

Going down the rabbit hole of last-mile logistics is a bit beyond the scope of this article, but I think the idea that everything will be delivered by Uber (Private:UBER) or drones is somewhat unrealistic, in a reasonable forecast period, outside of high population density areas like San Francisco or Manhattan. Technologists and analysts may live in these areas and assume the rest of the world is just like them, but that's not the case, and I think Wal-Mart's physical asset base (and supply chain) positions the company well for success.

Anyhow, the company is clearly not snoozing here; commentary at the Investor Day in the fall (see here) demonstrates that it is well aware of the threats posed by the evolving retail/e-commerce landscape. As I mentioned, I'm particularly impressed by pickup, but I think the company's vast supply chain network and ability to fulfill demand in multiple ways, from multiple locations, can be leveraged to give the consumer the best service possible. The approach is to make the consumer experience holistic, such that there's no mental differentiation between shopping in a store and shopping on the website - either way, you're shopping at Wal-Mart.

The investments required here may depress earnings in the short term, but I think taking the threats seriously and optimizing the business for the next 20 years - rather than the next 2 years - is absolutely the right move by management. CEO Doug McMillon may be baby-faced, but don't be fooled - he seems very sharp.

Of note, paying employees more is not charity; I think it will meaningfully improve morale and allow the company to better achieve its "clean-fast-friendly" goals. These are critical in maintaining the value proposition and keeping people shopping there, especially since one of the company's goals is to increase its penetration among more affluent consumers. (Wal-Mart doesn't currently under-index here, contrary to popular opinion - it just wants to do more business with this segment.)

How Does That Translate To Valuation?

I think there's an interesting discrepancy between the valuation afforded to Wal-Mart as it navigates through this transitional period, and the valuation afforded to mega-cap peers like Procter & Gamble (NYSE:PG) and McDonald's (NYSE:MCD). Both of those stocks are trading at well over 20x earnings as the companies undergo their own set of challenges. As I've discussed (here and here, respectively), I don't think those valuations are particularly justified, as both companies face obstacles that I believe are structural. Wal-Mart's "problems" are, at worst, of the same significance - and at best, somewhat less significant.

Yet, Wal-Mart's implied guidance suggests that "trough" earnings in FY17 should still be $4/share or better; analyst consensus appears to be $4.17. Even with the recent run-up, you're looking at under 16x trough earnings. You can, of course, make the argument that future EPS is being propped up by buybacks - but that's non-unique. The same goes for PG and MCD.

We can split hairs over whether PG, MCD, and WMT have significantly different long-term growth profiles (feel free to engage in the comments section). Perhaps WMT does deserve somewhat of a lower multiple. On the other hand, I do think the e-commerce threat is less of a big deal than the threat of the healthy eating trend, or the challenges faced by many of PG's brands.

Given that I like Wal-Mart's business better than McDonald's or Procter & Gamble's over the long term, I'm inclined to say the former deserves a valuation somewhere between what it trades at today and what the latter two trade at (since I believe them to be overvalued). What multiple is fair is admittedly subjective, but I think a price somewhere in the $70s rather than the $60s makes sense to me. That's not enough of a discount to make me personally interested, but it's more attractive than many high-quality mega-caps. Shareholders do need to be prepared, though, for the possibility of a lack of investor interest (or even further declines) through the transition period.

Wrapping It Up

Wal-Mart's earnings over the next few years will not be fully reflective of its potential. That said, I don't think there's a reason to believe the company will not be able to execute to plan, and buy-and-hold investors could do worse than using weakness in shares to build a position for the long term. Whether you agree or disagree, I'd love to know why... leave a comment.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.